How should macroeconomics be taught to undergraduates in the post-crisis era? A concrete proposal

Wendy Carlin, David Soskice25 October 2012

Is economic teaching keeping up with the changing economy? This column presents a new way of teaching economics in light of the continuing crises. It argues that if we are to create a better-informed public debate we must begin by improving the economics curriculum and our students’ ability and their willingness to communicate about economic ideas and issues.

Economics students have started to establish new student societies, which focus not on how to get a job in the City, but on the question ‘How can economics be used to understand the world better and improve it?’ This suggests an increasing appetite to participate in policy discussions. But how well-equipped are they to engage in debates about the causes of the Eurozone crisis or the conflicting claims about austerity policies, or whether quantitative easing will lead to inflation? Do they feel more confident to discuss those questions than their peers who study physics or anthropology? Diane Coyle (2012) reports the dissatisfaction of employers of young economists about their training; they need to know more about the economic conjuncture, economic institutions, and the operation of the financial system, as well as enough economic history to provide a context for current policy debates.

Are the revised versions of popular macroeconomics textbooks an adequate response to the challenges thrown up by the crisis? Do they equip the new generation of undergraduates – for whom crisis has been the continuous background to their lives since the age of 13 – to evaluate the economics commentary in the Financial Times and The Economist or the many, often conflicting, economics blogs; and can they explain their views to their non-economist peers?

A visible gulf exists, in the cases of such textbook writers as Blanchard (2011) and Krugman and Wells (dated 2013 but available now), between what the authors say in their opinion columns, blogs and speeches and what they say in their textbooks. Both of these textbooks contain new sections dealing with the crisis. The liquidity trap is explained but there is no modelling of how the crisis arose. Both books use IS/LM as their core model and the Mundell-Fleming variant for the open economy. Inflation-targeting by central banks is discussed in chapters on monetary policy but, since it is incompatible with the IS/LM model, it is not integrated in either the core modelling or in the discussion of the crisis and its origins. The 7th edition of Mankiw’s textbook (2010) follows a similar pattern, general equilibrium modelling being done using IS/LM. Mankiw does devote one chapter to deriving a ‘dynamic AD/AS model’ but does not use it in the chapter where inflation targeting is discussed.

None of these books bring the financial sector into the core macroeconomic model and so, although they provide insightful discussions of the financial crisis, they remain essentially descriptive. There seems to be a lack of ambition in the response of popular textbooks to the challenges presented by the crisis. We are presently writing a new undergraduate macro textbook, influenced both by the need to understand the continuing macroeconomic crisis in Europe and North America and by the signs that students’ expectations and needs are changing.

In our view undergraduates need a unified integrated model through which they can understand the major business cycle events of the past century and see how economic theories and policy regimes have evolved in response to these events. We have already developed part of such a framework in two previous texts published in 1990 (emphasising the supply-side and the stagflation of the 1970s and 80s), and in 2006 (emphasising the inflation-targeting regimes that emerged in the 1990s). Now, in a third book to be published in 2013, we integrate the financial sector into the model, showing show how a financial crisis can develop in an economy even while inflation targeting is being successfully carried out.

What are the differences between our approach and that taken in typical macro textbooks and undergraduate courses?

In our approach, there is a single general equilibrium model (the three-equation model plus financial sector) to explain how the economy works in both good and bad times; we do not need a different model to deal with the ‘pathologies’ of high unemployment or stagflation or depression or asset price bubbles.

In constructing a model that matches key features of real-world economies, we adopt an original modelling strategy. Instead of avoiding explicit micro-foundations altogether, or starting with unrealistic competitive assumptions, we take as our starting point an economy with imperfect competition in product markets in which a variety of institutional forms of wage setting, including efficiency wages, results in equilibrium unemployment. We assume that there is a mixture of credit-constrained and unconstrained households and firms, and that fiscal policy is non-Ricardian, so that the financing of government expenditure matters.

This single model explains how output, unemployment, and inflation are determined. Using it as a framework students can analyse developments in the real world: rapid changes in demand (such as a housing boom) and in supply (such as technology shocks, changing forms of wage bargaining, labour market deregulation, shifts in product market competition, and commodity price shocks). Such a model depicts an economy which is not self-stabilising. If the economy is to be kept close to a constant-inflation equilibrium purposeful policymaking is indispensable.

The objectives of policymakers are specified explicitly. This means we can model how the central bank or the government analyses the consequences of the shocks that affect the economy. The analysis allows for uncertainty in the economic environment and for lags in the effect of policy on the economy. Forecasting and the way expectations affect the constraints on the policymaker are part of the core model. Most of this was contained in the three-equation model (IS-PC-MR) in our previous book (Carlin and Soskice 2005).

Now, in our new book, the same model is extended to deal with the open economy. We show how the foreign exchange market interacts with the central bank in forecasting the effects of shocks and in determining the mix of exchange rate and interest rate adjustment to them (for an initial presentation of this, see Carlin and Soskice 2010). The case of a common currency area is handled within the core model enabling students to see how the Eurozone economy worked in its first decade and how an attitude of benign neglect by national policymakers towards stabilisation policy contributed to the origins of the sovereign debt problem.

The new book includes three chapters addressing the most glaring absence in macroeconomic models and courses, that of the financial sector. We integrate a model of the banking system with the macro-model, showing how the margin of the lending rate over the policy rate is set in the commercial banking sector, how money is created in a modern banking system and how the central bank takes account of the working of the banking system (and of government funding needs) in order to achieve its desired policy outcome. This produces the three-equation model plus financial sector.

Having included the commercial banking system in the core macro-model, we extend the model further to include highly-leveraged financial institutions and the transformation of risky loans from the balance sheets of commercial banks into marketable securities (in the spirit of Shin 2009 and Geanakoplos 2009). This step provides the tools to analyse how a leverage cycle can take hold in the economy. The modelling of a financial crisis and the consequences for policymakers of a subsequent balance sheet recession is also done within the same framework (reflecting the approach of Eggertsson and Krugman 2012).

Is teaching the three-equation model plus financial sector to undergraduates practical? The large number of students in the UK and Europe doing specialist degrees in economics can certainly be taught the formal (diagram-based) modelling, especially if the repetition that currently characterises the principles and intermediate levels of macroeconomics teaching in many universities could be reduced. It is also quite feasible for students on degrees with a smaller economics component to be taught the logic of the core model (without deriving it explicitly) and shown how to use it to interpret the behaviour of policymakers and macroeconomic performance data.

In addition to the initiative of the UK Government Economic Service and the Bank of England (reported in Coyle 2012), a major push to renew the economics curriculum is being supported by the Institute for New Economic Thinking, INET. A new INET project will generate new teaching material (to be delivered in the class-room and via the internet) and will explore innovative approaches to both the teaching and wider communication of economic concepts and models. This is a matter of broad public interest because citizens – most immediately in Eurozone countries – are being asked to make choices between different macroeconomic scenarios. They are usually obliged to make these choices with only a minimal understanding of the issues involved. If we are to create a better-informed public debate we must begin by improving the economics curriculum and our students’ ability and willingness to communicate about economic issues.